January 6, 2020

Client Assets: regulatory focus should be a red flag for firms in the DIFC and ADGM

In this article we look at the client assets rules (CASS) applicable to UAE financial free zone firms. We discuss why firms should pay close attention to CASS, particularly in light of an ongoing Dubai Financial Services Authority (DFSA) CASS thematic review.

A heavy focus will continue on how our regulated firms manage client assets. As we have no tolerance or misappropriation or mismanagement of client assets and monies, we expect all regulated firms to maintain proper systems and controls for the safeguarding and segregation of client assets

Introduction

The CASS regimes in the Dubai International Financial Centre (DIFC) and Abu Dhabi Global Markets (ADGM) apply to firms which ''hold or control'' client money or client investments, or which provide or arrange custody.

Although the focus of this article is on the DIFC, it applies analogously to firms established in the ADGM, which has a very similar CASS regime.

Why is CASS important?

The CASS rules are very complex and technical. Perhaps for this reason, they are often misunderstood by firms. However, when things go wrong from a CASS perspective, the outcome can be disastrous. Think Lehman Brothers' collapse, with the resultant client money issues and litigation that ensued. In the UK, the Lehman CASS litigation continued for years, severely delaying repayments to investors. Regulators take CASS rules breaches extremely seriously due to the risk of client losses. This also means that CASS breaches are likely to attract closer regulatory scrutiny and tougher regulatory sanctions.

Why compliance with CASS should be a priority

First, the DFSA's Supervision division commenced a project in 2019 to examine firms’ efforts to safeguard client assets, and related audit practices. This project will run into 2020 and will look at various aspects of the CASS regime and how firms, and their auditors, apply the requirements of the regime.

Second, in the DIFC, one helpful gauge to assess whether firms should pay closer attention to a particular aspect of the rules is found in the DFSA's latest Business Plan. A good rule of thumb is that if something is mentioned more than a couple of times in the Business Plan, this is usually a sign that the DFSA will be focusing on this particular theme during the relevant period. In the 2019/2020 Business Plan, the DFSA mentions CASS a total of 9 times. Note by comparison that AML, which is generally viewed as the DFSA's key priority, is mentioned only 8 times. To quote the DFSA's 2019/2020 Business Plan:

''A heavy focus will continue on how our regulated firms manage client assets. As we have no tolerance or misappropriation or mismanagement of client assets and monies, we expect all regulated firms to maintain proper systems and controls for the safeguarding and segregation of client assets […] We will prioritise investigations and enforcement actions towards certain activities. This includes […] Misappropriation and mismanagement of client assets.''

It is no surprise that CASS is one of the four core areas of focus for DFSA enforcement action in 2019/2020. The 2014 insolvency of ES Bankers Dubai, and the more recent collapse of Abraaj, have called into question the protection of client assets in the DIFC. The DFSA has reacted by focusing enforcement action on CASS issues, hiring specialist staff and creating a dedicated CASS team within its Supervision division.

What are the key areas of CASS compliance where problems can arise?

We set out below some of the more common CASS compliance issues that we have encountered in the past which firms should be aware of.

Application of CASS to firms

According to the DFSA, more than half of the authorised firms in the DIFC have activities that give rise to CASS obligations. However, one regular issue that we have seen is where a firm is not aware that the CASS rules apply to one or more parts of its business. This issue is most likely to occur in the following circumstances:

  • Where a firm is not aware that it is in fact ''holding or controlling'' client money.
  • Where a firm believes that it is merely arranging custody but is in fact providing custody.
  • Where a firm which is arranging custody is not aware of the applicability of the CASS rules to such activities.

Category 4 firms holding client money

The DFSA and FSRA CASS rules prohibit Category 4 firms from holding client money. A common mistake that we have seen is where a Category 4 firm holds client money without realising that it does. Typically, this is due to the firm failing to understand either the definition of client money, or when it is deemed to be ''holding'' client money.

The banking ''opt-out''

The DFSA and FSRA CASS rules provide that money is not client money if it is held by a firm 'as a bank ''in an account with itself'', provided the firm notifies the client in writing that the client money is held by it as a bank and not in accordance with the CASS rules. This exclusion from the application of the CASS rules is often misunderstood and also has a very narrow application, in that it is only available to banks holding money as a deposit.

Client accounts

The common issues that arise in respect of client accounts are:

  • A failure to undertake any, or any adequate, prior assessment of the suitability of the bank at which the firm holds its client account(s), including assessing whether bank will ''provide protections equivalent to the protections conferred by CASS''.
  • A failure to assess the ongoing suitability of the bank at which the firm holds its client account(s). This would typically require a periodic review of the ongoing suitability of the bank and the recording of the firm's basis for considering the bank to remain suitable to hold client money.
  • Failing to ensure that its client accounts include the words "Client Account" in its title.
  • A failure by non-DIFC firms (i.e. a branch of a foreign firm) to ensure that its client accounts are maintained in the name of a nominee company controlled by the firm (note that this has an ongoing cost implication).
  • A failure by the firm to obtain written acknowledgement from the bank at which the firm holds its client account(s) stating that all money standing to the credit of the account is held by the firm as agent and that the bank is not entitled to combine the account with any other account or to exercise any charge, mortgage, lien, right of set-off or counterclaim against money in that account in respect of any sum owed to it on any other account of the firm.

Reconciliation issues

Some common issues in respect of reconciliations of client accounts are a failure by firms to:

  • Carry out the reconciliation within 10 days of the end of the month (reconciliations must be completed at least every 25 days).
  • Ensure that the reconciliation compares the firm's internal ledger balances with the firm's external bank account balances at the correct point in time and adopting the correct FX rates.
  • Make good any shortfall in the client money account whilst any discrepancies are being resolved.

Additionally, good record keeping by firms, particularly in respect of reconciliations, is crucial. This is because regulators will often place the onus on firms to demonstrate that reconciliations have been properly undertaken. Poor or incomplete record keeping can result in enforcement action for failure to undertake reconciliations.

Other CASS issues

Other CASS issues that we encounter from time to time include difficulties that firms have in hiring staff with adequate knowledge or experience in the CASS rules, and a similar lack of CASS knowledge by a firm's auditors.

Additionally, firms sometimes apply the CASS rules without taking into account the overarching purpose of the CASS rules, which is to ensure that the firm has adequate systems and controls to minimise the risk of the loss or diminution of client assets, which may result from the firm's or a third party’s insolvency, fraud, poor administration, inadequate record-keeping or negligence. This can result in technical compliance by the firm, but still exposes the firm to enforcement action for failing to comply with Principle 9 of the Principles for Authorised Firms.

Recommended action

In light of the DFSA's ongoing CASS thematic review and the increased focus on CASS by its Enforcement Division, we recommend that firms undertake a health-check on their CASS compliance to ensure that the CASS rules are being correctly applied, to avoid the risk of potential enforcement action against the firm, and its employees.

For more information or advice about the DFSA or FSRA's CASS regime please contact one of our specialist partners.